Journal Article

Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications

Bruno Biais, Thomas Mariotti, Guillaume Plantin and Jean-Charles Rochet

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 74, issue 2, pages 345-390
Published in print April 2007 | ISSN: 0034-6527
Published online April 2007 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1111/j.1467-937X.2007.00425.x
Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications

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  • Information, Knowledge, and Uncertainy
  • Economics
  • Corporate Governance

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An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diffusion reflected at the dividend barrier and absorbed at 0. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-to-market ratios are in a non-monotonic relationship. A more severe agency problem entails lower price-earning ratios and firm liquidity and higher default risk.

Keywords: D82; G12; G31; G32

Journal Article.  22873 words.  Illustrated.

Subjects: Information, Knowledge, and Uncertainy ; Economics ; Corporate Governance

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